Caledonia Products Integrative Problem 1. Why should Caledonia focus on project free cash flows as opposed to the accounting profits earned by the project when analyzing whether to undertake the project? Free cash flows are being focused on because it the amount that Caledonia will receive and they will be able to reinvest that amount. Caledonia should analyze the free cash flow so that they are able to see the real amount of value or what the cost may be. The marginal value from the project would be in the incremental cash flow. The earnings would be much less if they were looking at it through the accounting profits.
It would be less because of the depreciation would be considered an expense causing a larger expense for Caledonia. Describe factors Caledonia must consider if it were to lease versus buy First Caledonia must figure out if they will have enough cash flow to pay the bill each month. Leasing would give Caledonia the benefit of decreasing costs. The down side of leasing would mean that Caledonia will not be out of the lease until it has been paid off and the company who leased the property will be the owners until that is completed.
Buying property means that the item is usually in better condition, better value, and they will own it. Prices are often better when buying than with leasing. Tax expenses may be a downside of owning the property. 2. Incremental Cash Flow Year1 Year2 Year3 Year4 Year5 Operating Cash Flow 5,949,200 9,909,200 11,493,200 6,741,200 3,771,200 Each year results in positive incremental cash flow and the new project appears to be a profitable business option.
Accounting profits represent the total cost of doing business. The difference would be that this company requires additional net working capital every year which is not reflected in the incremental costs. 3. Initial Outlay Year 0 New Product Cost of new plant and equipment$(7,900,000) Shipping and installation costs (100,000) Total costs$(8,000,000) Initial working capital $(100,000) Initial cash flow (8,100,000) 4. Free Cash Flow
Year0 Year1 Year2 Year3 Year4 Year 5 Project Revenues $21,000,000 $36,000,000 $42,000,000 $24,000,000 $15,600,000 Unit Costs (12,600,000) (21,600,000) (25,200,000) (14,400,000) (10,800,000) Gross Profit 8,400,000 14,400,000 16,800,000 9,600,000 4,800,000 Annual fixed costs (200,000) (200,000) (200,000) (200,000) (200,000) Depreciation (1,580,000) (1,580,000) (1,580,000) (1,580,000) (1,580,000) Net operating income 6,620,000 12,620,000 15,020,000 7,820,000 3,320,000 Taxes (34%) (2,250,800) (4,290,800) (5,106,800) (2,658,800) (1,128,800) NOPAT 4,369,200 8,329,200 9,913,200 5,161,200 2,191,200 Depreciation 1,580,000 1,580,000 1,580,000 1,580,000 1,580,000 Operating cash flow 5,949,200 9,909,200 11,493,200 6,741,200 3,771,200
Year0 Year1 Year2 Year3 Year4 Year5 Net Capital $(100,00) (2,100,000) (3,600,000) (4,200,000) (2,400,000) (1,560,000) CAPEX $(8,000,000) — —- —- — — Free Cash Flow $(8,100,000) 3,849,200 6,309,200 7,293,200 4,341,200 2,211,200 5. 6. 7. Should the project be accepted? Why or why not? Yes. This project should be accepted because the NPV ? 0. and the IRR ? required rate of return. Or No. This project should not be accepted because the NPV < and the IRR < required rate of return.